As warned earlier, Treasury proposed rules to block a state and local tax (SALT) deduction workaround strategy that had been adopted by New York, New Jersey, and Connecticut, and was being considered by several other high-income-tax states. Under the strategy, taxpayers would be allowed a credit against state taxes for contributions to state- or local-run charitable funds that provided money for public services. The strategy was intended to sidestep the annual $10,000 cap on SALT deductions for federal income tax under the Tax Cuts and Job Act (TCJA). The goal of the workarounds: convert newly non-deductible state tax payments into deductible charitable contributions, which could save state taxpayers money and fund public services.
Treasury’s proposed guidance would block those plans. And, despite objections, Treasury also applied the new limits to pre-existing state tax credit programs, notably those for private school scholarships.
In the proposed guidance, Treasury announced a quid-pro-quo rule, which requires a taxpayer to reduce her federal income tax deduction for a charitable contribution by the amount of any state tax credit she receives (or the amount of any state deduction that exceeds the value of a contribution). Treasury would exempt from the limitation state tax credits that are 15 percent or less of the value of the amount contributed. For a long time, deductions for charitable contributions have been reduced by the fair market value of goods or services that are received in return but, previously, state tax credits have not been treated as goods or services.
The rule would work this way: Suppose a taxpayer contributes $1,000 to a charitable fund and the contribution is eligible for a $1,000 state tax credit. Prior to the proposed rule, a resident in a state with a workaround plan may have been able to claim both the $1,000 state tax credit and a $1,000 federal charitable deduction. Under the proposed rule, the taxpayer would be able to claim only the $1,000 state tax credit, not a federal charitable deduction (since the value of the credit is subtracted from the amount contributed). If the gift were eligible for an $850 state tax credit, the federal charitable deduction would be $150 (computed as $1000 - $850).
The newly proposed limits will discourage taxpayers in New York and other states from contributing to state-run charitable funds since both the state tax credit and the federal income tax deduction are key to the idea. But the new guidance could also limit federal tax benefits for pre-existing state credit programs, like those in Georgia and South Carolina, which offer a dollar-for-dollar state tax credit for contributions to school scholarship funds.
Under pre-TCJA law, donors to these pre-existing state credit programs could additionally claim a charitable contribution deduction but they would also reduce their SALT deduction by an equal amount, which generally would make it a wash for federal income tax purposes. However, taxpayers subject to the alternative minimum tax (the AMT) for federal income tax purposes got an additional federal bonus from turning a SALT deduction into a charitable contribution deduction. That is because the AMT did not permit SALT deductions, but permitted charitable contribution deductions. Today, the AMT limit is no longer an issue, but the TCJA deduction cap is.
Although Treasury applied the new limits to pre-existing state programs, it lauded “the value of state tax credit programs, particularly school choice initiatives.” But Treasury added that “only about 1 percent of taxpayers will see an effect on tax benefits for donations to school choice tax credit programs.”
1 percent sounds low, but 1 percent of what? All taxpayers? All itemizers? Taxpayers who contributed to these programs last year? In any event, many more taxpayers may have expected to benefit from these pre-existing programs, and from the SALT workarounds, after the TCJA. That hope, for now, may be dashed for contributions after the proposed effective date of August 27, 2018.
The proposed regulations are somewhat lighter-than-expected for the new SALT workaround credit programs (with a 15 percent de minimis exemption), but harsher-than-expected for the pre-existing credit programs. Of course, comments on these proposed regulations will be accepted in the coming weeks, meaning changes still could be made. So, stay tuned.
